The Securities and Exchange Commission today announced a settlement with F-Squared Investments for $35 million and an admission that the firm defrauded investors through false performance advertising.
F-Squared's co-founder and former CEO, Howard Present, was charged separately for making misleading statements to investors.
In 2008, the Massachusetts-based startup launched its flagship product line, AlphaSector, a suite of exchange-traded funds.
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The new funds used a buy/sell signaling system based on a third-party's algorithm that rebalanced portfolios, claiming downside protection for falling markets while retaining the ability to capture returns from improving markets.
The AlphaSector products propelled F-Squared from a foundering startup to the largest marketer of index products using ETFs.
Part of the marketing strategy involved claims the firm and former CEO Present made regarding a successful seven-year track record for the strategy.
But the algorithm the ETFs where built around wasn't even around during the seven years of purported success.
F-Squared based those claims on so-called backtesting, which applies an investment model to historical data to generate a hypothetical performance track record.
Marketing material, authorized by Parent, specifically advertised the purported returns as not backtested, but based on actual returns.
On top of that, the historical data the firm pitched included a calculation error that inflated results by as much as 350 percent.
The SEC's investigation alleged that calculation error was pointed out to Present in late September 2008, but the firm, at the behest of its leader, went on to advertise the inflated data for the next five years, overstating claims that the AlphaSector products outperformed the S&P 500 from April 2001 to September 2008.
"Investors must be able to trust that performance advertisements are accurate," said Andrew Ceresney, director of the SEC's Division of Enforcement. "F-Squared has admitted that it misled its clients over a number of years about the existence and success of its core strategy."
The U.S. ETF market holds about $1.8 trillion, according to Cerulli Associates. Traded on exchanges like individual securities, they are touted as a low-cost strategy for portfolio diversification.
F-Squared managed $25.6 billion in assets at the end of last June, up 80 percent from the previous year, according to Morningstar.
The Premium AlphaSector Index posted a five-year gain of 19.47 percent as of last June, and charged 60 basis points in fees, less than the average of 69 basis points for large-cap mutual funds.
In November, the company announced Parent would be stepping down as CEO. Laura Dagan, previously a member of the company's board, stepped in to replace him.
"We are pleased to put this matter behind us so that we can focus on our clients and continue to invest to ensure that our compliance, research, analytics and operational teams are best-in-class," said Dagan in a statement.
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Nick Thornton
Nick Thornton is a financial writer covering retirement and health care issues for BenefitsPRO and ALM Media. He greatly enjoys learning from the vast minds in the legal, academic, advisory and money management communities when covering the retirement space. He's also written on international marketing trends, financial institution risk management, defense and energy issues, the restaurant industry in New York City, surfing, cigars, rum, travel, and fishing. When not writing, he's pushing into some land or water.
